How This Options Trader Shorts Netflix – Seeking Alpha

Summary

Shorting stocks, especially ones as volatile as Netflix, is no easy task.

Long-dated, slightly out-of-the-money put options provide the asymmetric payout needed to mitigate the imbalances of being outright short stock.

My choice is the NFLX January 2017 $100 strike puts.

Investors can lose 100% of capital invested when purchasing options. Only invest what can be lost entirely.

Consider selling half of the option if up 100% in the trade to mitigate option decay.

Earlier this week, I published Why I’m Short Netflix (NASDAQ:NFLX), pointing out some red flags in the company’s financial statements and my rationale for why I think Netflix is extraordinarily overvalued and a prime short candidate. User comments on my article spanned from the bulls telling me good luck and that I must like losing money to the bears saying I was spot on, but they had tried and failed shorting a stock that could rip by 50% in a few months. I responded by saying I owned the NFLX January 2017 $100 strike puts that gave me an asymmetric payout with very low decay. A few asked why exactly I was doing this and how I decided to structure my options trade, so here’s my quick explanation.

The Danger of Shorting

Anytime I take a short position in a stock, I never actually short the underlying. An investor who is short stock has an asymmetric return profile that works against them; stocks can theoretically spike to infinity, but can only fall to zero. The October 2008 price spike in Volkswagen’s (OTCQX:VLKAY) (ETR: VOW) shares is a beautiful example of this. Market participants assumed a certain float was available to them to short VOW. Porsche (OTCPK:POAHY) unveiled an option position that meant it owned the majority of VOW float outstanding, leading to one of the largest short squeezes in history.

(click to enlarge)

Source: Bloomberg

Market participants who were outright short the stock were forced to cover at outrageous prices, wrecking some hedge funds. Had those same funds owned longer-dated puts, they would have never been forced to cover in that upward onslaught, and would have had the luxury of waiting for the market to cool down, which it eventually did, a month later.

The downside to owning puts is that an investor bleeds premium every day he is long the option. This is called “theta bleed”. Keep in mind, with options onecan lose every penny invested, especially with out-of-the-money contracts. Approaching expiry, the premium paid erodes at a faster and faster rate every day, all else equal. The hope as an investor is to recoup the premium paid and then some in the form of intrinsic value (the difference between strike and the stock price, if it is below strike, in the case of put options). I also have the intention of trading out of my options position if the trade goes in my favor to a certain extent. I have no intention of holding the trade to expiry, so I hope to profit from a movement both in the stock price lower, adding to intrinsic value, plus some degree of remaining option premium at the time I decide to unwind the trade.

Dollar Amount to Invest

I only invest what I’m comfortable with losing entirely. For me, I will invest between 33BPS (0.33%) and 1% of the portfolio I am managing. Many times I will divide the trade in thirds so that I can double down and a triple down on the trade – so 33BPS, 33BPS, 33BPS, for a max exposure of 1%. That way if my downside scenario pans out, I’ve made (in the case of the 1/17 $100 strike puts) 280% on my money and have a 3.8% portfolio position. The max amount to dedicate to a trade is up to the risk tolerances of each investor, but I advise determining that well ahead of time to prevent trading with emotions.

The Structure – Time to Expiry

Time to expiry for my style trades (looking to take advantage of longer-term mispricing) requires me to find options with the lowest decay possible. That is why I choose the longest contracts I can get my hands on. They give you the longest amount of time to profit to the downside, and also have the lowest daily decay rate (theta bleed). Below are NFLX $100 strike options across the term structure (through time to expiry) and the associated theta bleed of a one contract position:

Source: Bloomberg

Note that theta bleed is only $2.48 a day for January 2017 expiries versus shorter-term contracts at more than $6 a day. Of course, there’s no free lunch in that the price you must pay for the longer-dated options is much higher, meaning you can’t control as many shares for the same dollar invested in longer contracts.

The Structure – Strike Price

The strike price of an options trade depends on your outlook for the underlying stock. In my case, I am very bearish Netflix. I have a $35 price target, or a 40x EV/EBITDA multiple. So I do not want to cap my downside by using a put spread (buying one near money option and selling a farther out of the money one). I want to simply own a put that will give me the largest upside to my target price. I do not, however, want to buy a lottery ticket. The farther out of the money one goes, the cheaper the option, and the larger the potential payout, but that also comes with a higher probability of losing the entire investment. Below are the potential payouts assuming Netflix hits my $35 price target:

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What I also like to do is put my strike selection in the context of the prior price movements over the same term to expiry. For example, the January 2017 expiries have 436 days remaining. Moving back in time, 436 days get you to 9/1/2014. Of course, past performance doesn’t indicate future results, but I find it helpful to see historical movements of the stock.

The graph below shows Netflix’s price performance from 9/1/2014 onward. I’ve highlighted the strike of my selection, the $100 strikes in white and that contract’s breakeven price of $100-$17=$83. (I’m not a huge fan of breakeven analysis because I rarely hold options to expiry, but I’ve put it on there since many look at this metric). I chose this strike because there is a decent probability it is in the money given that it is relatively close to spot price at the moment, $113.66, or 88% of the stock price, but will also payout a decent 282% return in the event the stock reaches my price target.

(click to enlarge)

Implied Volatility

The most important component to option pricing is the implied volatility of the option. It is an excellent way to compare options to determine relative value and compare relative richness/cheapness though time. It is also incredibly important to check to make sure one is not paying too much for an option. Currently, the NFLX January 2017 $100 strike puts are offered at 51.25 implied vol. Compare that to the SPX index (NYSEARCA:SPY) 1/2017 185 strikes at a 20.25 volatility. More than double the volatility, but that is common for a single name stock, especially one as volatile as Netflix.

Comparing the NFLX option implied volatility through time:

(click to enlarge)

Source: Bloomberg

Note that we are considerably off the lows in implied volatility, but that was when Netflix’s stock was trading in the $50s, and investors weren’t buying options to bet to the downside on the stock. The good thing is we are roughly at the median implied volatility for the past five years in this particular contract. As a general rule in equities, I would consider a 25 vol and lower to be relatively low, a 50 vol to be high but not incredibly expensive, and a 75 vol and higher to be very expensive.

Exit Strategy

Given the decay an outright long options investor faces, he must have a viable exit strategy for the trade. The first and foremost component to my strategy is not investing too much of my portfolio in the options to begin with, hence my 1% max exposure rule. The second component to that is to sell half of the option contracts if I’m up 100% on the trade, that way I’m taking the cost out of the option. This helps mitigate the decay. I have seen situations where I was up 100% or more quickly, only to hold it and watch the stock reverse slightly and the premium decay away to nothing. After taking cost out of the trade, use discretion as to when to unwind the balance. I usually let the balance of the position ride, unless I believe something fundamental has changed, or the option is extraordinarily well bid.

Conclusion

Shorting any stock, especially Netflix, is not an easy task. Put options provide the asymmetric payout needed to mitigate some of the risks associated with shorting stocks outright. Longer-dated, slightly out-of-the-money options provide the best way to capture downside with minimal decay, in my opinion.

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